Really THINK About What You are Saying if You Think Rates Are Coming Back Down

[Scott Trench]

I continue to have arguments with close friends and colleagues about where rates are headed in the next year. And, while it's anyone's guess, I just continue to think that some investors are a little crazy/deluded to think that rates are coming down quickly. 

The only way rates come down in the next year or two in a meaningful way, is if our Federal Reserve completely screwed up, the rate hikes cause a massive recession/depression, a bubble bursts, and mass job loss/deflation forces them to reverse course quickly. 

Saying that rates are going to get back down to the 4-5% range in the next year or two, is essentially arguing that the Fed are completely out of their minds right now to keep rates where they are, will cause a huge economic disaster, panic, and reverse course quickly. 

This is really an unreasonable argument, in my view. It's not going to happen. Even if the Federal Reserve is as dumb as some people think they are, for rates to come down, they have to self-actualize the (potential, theoretical, future) damage being done to the economy, admit defeat, panic, and rapidly reduce rates.

Guys - that is a bad bet in my opinion. The Federal Reserve are not some bunch of quacks who have no idea what they are doing. They are pretty good at their jobs. And, I bet that the Federal Reserve Board got to where they are by being confident, strong economic careerists. Even if they ARE as wrong as some of the pundits say, they aren't going to panic and undo rates overnight. 

I believe that our Federal Reserve is not some bunch of idiots. They screwed up two years ago and let inflation get out of hand. They have aggressively fought that inflation with clearly effective economic policy since. They have caused economic pain, but not disaster. GDP continues to grow, employment remains high. Inflation is nearing it's target. 

A far more reasonable bet is that the Fed does exactly what they say they are going to do - they raise rates another 25-50 bps. They stop. The yield curve normalizes. The current rates set in, and we continue on our merry way with a new "normal" for Federal Funds rate for the next few years, and asset values reflect the new order. 

I keep getting called crazy for calling the yield curve normalizing in the next year or two, and the 10-year marching to 5%, 5.5%, and beyond. But, I think that this is the obvious, logical outcome of the current Fed Policy and believing what they are saying. In my view, it's simply going to happen. And I am planning accordingly.

[JD Martin]

Here is my best guess at what is going to happen in the not too distant future:

1. Housing & real estate as a percent of GDP is going to decline, perhaps dramatically, as things start to seize up or downsize. No inventory because no one wants to give up 3% interest rate mortgages for 7% mortgages. No buyers because no one can afford 500k houses at 7% rates. So the housing market stabilizes but far, far smaller than it has been. All of the ancillary businesses that depend on constant buy & sell of housing start to collapse - furniture stores, refinance officers, real estate agents. 

2. Commercial real estate that is financed with variable rates starts to have a much higher rate of default. MFH projects that depended on "cashing out" every 3-5 years become albatrosses that can't find buyers and can't raise rents without increasing vacancies.

3. REITs start to fail because of the cash required to prop up the investments.

4. New construction sputters and stalls because of the high cost of labor and materials coupled with high mortgage rates. 

5. Eventually the FED lowers rates to try to combat all of the above. Whether that's in a year or 5 years there's no way to know. 

One thing I think is for certain is that the FED doesn't like to admit defeat. Dropping rates to zero at the outset of COVID was foolish and unnecessary. RE and housing may have been on a long-term unsustainable trajectory before that, but they supercharged it. Now that housing prices went through the roof and everyone refinanced, it's going to take a long time to work that through the system and the high rates in the meantime is going to destroy the RE market in the short term. I don't think it would be such a big deal except that housing & it's ancillary businesses have become such a large part of our economy. The FED painted itself into a corner with low rates - perhaps lower than they needed to be for years - and now they're going to have to walk through the paint.